An attempt to explain in ordinary language the bizzare bazaar that is our financial system.

Thursday, October 23, 2008

Undropped shoes and the "Rumsfeld Effect"

A very interesting day in the stock market today. The morning began with some grim news from the economy. Jobless claims came out at 478,000 a huge number but only 8,000 worse than expected. Also some data came out about foreclosures which was also grim as they are 17% worse than this time last year though only 3% worse than last quarter so things are getting worse but more slowly.

The interesting thing about this is what the market did: nothing. The market traded sideways and actually climbed in the morning before doing another dive for the deck routine in the middle of the day before recovering in the last hour to close up a percent or so.

So why is this happening? I think there are two things at work here, the first is that now that no one doubts the resolve of the government to do something about the financial crisis the market is looking to data about how the real economy has been effected by the crisis. Todays data and recent earnings have been bad, but not far worse than expected and apparently not worse than the market is pricing. So actually, in a way, even bad data is good for the market in the sense that it allows people to confront reality about the economy rather than their fears about it. This is why I think the market traded up in the early part of the day.

So why the dive for the deck and then rebound? I think the reason for that is more subtle. To explain it, I have to go back to my favorite quote from Donald Rumsfeld:

"There are known knowns. There are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don’t know. But there are also unknown unknowns. There are things we do not know we don’t know."

Regardless of your opinion of Mr. Rumsfeld this is a useful insight into the current markets. Remember that no one currently working in finance has ever seen anything like this. Many things that three months ago people thought would never happen have happened, and then happened over and over again all over the world. People are now forced to admit that not only are there things they are aware are risks, they also have to worry about things which may be risks to the system but have not yet occured to them and won't until its too late.

Essentially people are afraid of the things they know are risks: a slowing real economy and declining corporate earnings. But now they also have to be afraid of things they don't know might happen. What happens if a major hedge fund faces redemptions and is forced into liquidation? What if the loans to AIG are not enough? What if the government takes a forceful action which it poorly thought through and makes worse what it is trying to improve?

Addressing risks people are aware of is simple. Over time we will know how the denial of credit to the real economy has affected it and the earning power of companies within it. Addressing the fears of people who are not sure what they are afraid of is a whole other thing and far far harder.

Luckily, it is easy to predict the behavior of people who are afraid of things they imagine and of things they cannot imagine: they sell.